Policies to promote economic growth using AD–AS analysis

Overview

Cut in interest rates raise the growth rate, demand-side policy alone fail to raise the growth rate permanently and how education and training policy raises long-run growth.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain how expansionary fiscal policy raises economic growth in the short run, using AD–AS analysis.

   Model answer

   An increase in government spending adds directly to aggregate demand, and a cut in income tax raises households' disposable income and therefore consumption. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the AD curve shifts to the right. At the new equilibrium real output is higher, so measured growth increases, and the price level is also higher. How the shift divides between output and prices depends on the slope of short-run aggregate supply at that point: with a large negative output gap most of it goes into output, while near capacity most goes into prices.

2. 2

   How can a cut in interest rates raise the growth rate?

   Model answer

   A lower policy rate reduces borrowing costs for households and firms and lowers the return on saving. Households bring forward purchases of durable goods and housing and save less, so consumption rises, while firms find that more investment projects cover their cost of finance, so investment rises. The currency may also depreciate, raising net exports. Aggregate demand shifts right, so at the new equilibrium real output is higher. Investment carries an additional long-run effect, because the resulting capital stock raises capacity and shifts long-run aggregate supply right in later periods.

3. 3

   Why does demand-side policy alone fail to raise the growth rate permanently?

   Model answer

   Raising aggregate demand moves the economy towards and eventually onto its existing capacity, which closes a negative output gap and produces a temporary burst of measured growth. Once capacity is reached, further increases in demand meet a vertical long-run aggregate supply curve, so they raise the price level without raising real output. The economy's sustainable growth rate is determined by how fast capacity itself expands, which demand management does not affect. Demand policy therefore determines how fully capacity is used, not how fast it grows.

4. 4

   How does government investment in infrastructure affect both aggregate demand and aggregate supply?

   Model answer

   Building infrastructure is expenditure, so in the short run it adds to the government spending component of aggregate demand, shifting AD right and raising real output and the price level at the new equilibrium. Once completed, the infrastructure lowers transport, energy and communication costs for firms across the economy, raising productivity and the economy's capacity, so long-run aggregate supply shifts right, raising real output and lowering the price level. This dual effect is why infrastructure spending is attractive in a downturn: it supports demand immediately and capacity later.

5. 5

   Analyse how education and training policy raises long-run growth, naming the axes of your diagram.

   Model answer

   Education and training raise the stock of human capital, so workers become more productive and each hour worked yields more output. Firms can produce more from the same labour force, and the economy becomes better able to adopt new technology, which raises the return on physical investment too. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the long-run aggregate supply curve shifts to the right. At the new equilibrium real output is higher and the price level is lower, so growth is achieved without inflationary cost, which distinguishes it from demand-side policy. The limitation is timing, since a cohort educated now affects output over the following decades rather than in the current year.

6. 6

   How can tax policy be used to raise investment, and what is the mechanism?

   Model answer

   Reducing corporation tax raises the after-tax return on a project, so projects that previously failed to cover the required return become worthwhile and more investment takes place. Allowances that permit the cost of capital equipment to be set against taxable profits immediately have a similar effect and are more precisely targeted, since they reward the act of investing rather than the earning of profit. The resulting capital accumulation raises productive capacity, shifting long-run aggregate supply right. The cost is revenue forgone, and the effect is uncertain because investment depends heavily on expected demand as well as on the tax treatment.

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